After a brief period of decline following its autumn 2023 IPO, shares of semiconductor technology patent and licensing company Arm Holdings (ARM 4.11%) rocketed higher to close out the year. At the end of 2023, the stock was up nearly 20% from when it made its publicly traded debut.
The price runup can be attributed to investors who are optimistic that a resurgence in chip sales in 2024 could spell big financial gains for Arm. However, I'm not so sure the recent run higher in the stock can continue unabated. Here's why.
Arm gets ready to strongarm the AI market
Arm develops and owns intellectual property (IP) for key chip processor technology. One of its biggest customers is Apple, which uses Arm heavily for its iPhone and MacBook (M1, M2, and M3) processors. Arm earns revenue in two stages, as a typical patent and IP manager does: licenses and royalties.
Royalties are a small bit of revenue every time an Arm-based chip is manufactured. Arm has about 50% of global processor market share, much of it from the smartphone industry, so revenue tends to follow the pace of general industry sales and manufacture of chips. The smartphone and PC market bottomed out early in the calendar year 2023, so Arm's royalties are back on the rise.
Licensing revenue is realized when Arm strikes a deal for a semiconductor designer to access its processor patents and related IP, tools and design software, and other support services that can span from engineer training all the way to ultimate chip manufacturing assistance. Arm offers licensing in two basic packages: "Flexible Access" and "Total Access." As the names imply, Flexible Access has limits, while Total Access caters to Arm's biggest customers who want complete access to the company's portfolio.
In the second quarter of fiscal 2024 (the three months ended in September 2023), Arm said Total Access license agreements increased by two (both new licenses with the same customer) for a total of 22 (compared to just 13 a year ago), and Flexible Access license agreements increased by one to 212 (compared to 194 last year).
The spotlight has been shone on Total Access due to artificial intelligence as big tech companies grapple with the need to craft more energy-efficient processors. Processor energy efficiency is Arm's specialty, and it thinks it can scoop up lots more market share in data centers and PCs in the years to come -- a processor market currently dominated by the x86 processor duopoly Intel and Advanced Micro Devices.
While royalty revenue making a comeback is a good sign, it was the big AI-fueled jump in licensing in the latest quarter that had investors feeling fine. Arm revenue was up 28% year over year to $806 million for the quarter ended in September 2023, driven by a 106% gain in license sales to $388 million.
Reason for caution as 2024 gets rolling
It might be easy to associate customer licenses with subscription-style revenue, but licensing can be lumpy. Don't expect the big jump Arm just reported in this revenue segment to continue. To wit, third-quarter fiscal 2024 (for the final three months of calendar year 2023) revenue is expected to be in a range of $720 million to $800 million -- well below the last quarter's sales headline.
For reference, Q3 fiscal 2023 (the final months of calendar year 2022) revenue was $745 million -- when Arm financials were still fully reported under SoftBank Group (SFTB.Y 1.75%), which retains majority ownership of Arm even after the IPO. At the end of 2022, PC and smartphone sales were in the gutter, meaning that Arm's licensing and royalty revenue were near the bottom of the last industry trough.
It appears the rebound is now priced into the current stock price. Thus, rather than focus on Arm's top-line growth as it recovers from a depressed year, investors would be better off looking at the company's profitability. GAAP net losses ($110 million in net loss last quarter) are being driven by IPO-related stock-based employee compensation. Free cash flow (FCF) in Q2 fiscal 2024 was positive $193 million last quarter, a rebound from just $50 million the quarter a year prior.
Nevertheless, if simply annualizing Arm's FCF from the last quarter ($193 million multiplied by 4 equals $772 million), Arm Holding is currently valued at about 100 times free cash flow. Suffice it to say that's a high premium. More than a rally in the company's profitability as measured by FCF is needed to justify the current price tag.
After the successful IPO from Arm's owner, SoftBank, in the final months of 2023, I'm still on hold with this stock. In the meantime, there are better deals to be had in the semiconductor market for 2024.
